Islamic Finance Emerging as Blue Ocean

While major economies were rattled by the global financial crisis following the U.S. subprime mortgage trouble, some were relatively safe. Islamic finance is one of them. It survived the crisis thanks to stable management of assets based on Islamic law, and the world is paying attention to it as an alternative to Western-style finance.

Islamic Finance Growing Rapidly

Though still alien to most Koreans, Islamic countries form a major pillar of the world. They make up 17.8 percent of the global economy and the Muslim population represents 24 percent of the world’s total. The number of Muslims is expected to reach 3 billion in 20 years.

Islamic finance, or financial transactions and products that suit Islamic law, has been growing by between 15 and 20 percent each year.

The total assets of Islamic finance stood at over $700 billion as of 2007, and are expected to breach the $1-trillion mark within two years, upon oil price hikes and the growing interest of oil-producing countries in financial investment as they ponder how to manage huge amounts of oil money.

“The continuous oil price hike between the 1990s and 2000s enabled the Middle East to accumulate ‘oil money.’ Oil producers with political stability like Saudi Arabia, the United Arab Emirates, Kuwait and Iran had the fund grow steeply,” the Korea Trade-Investment Promotion Agency (KOTRA) said in a report.

The issuance of Sukuk, or Islamic bonds, grew to $42 billion as of 2007, increasing by over 40 times from 2002. The issuance of Sukuk, mainly used to fund infrastructure projects in the Middle East, is estimated to reach $150 billion by 2012.

Islamic funds are also experiencing explosive growth. The number of Islamic funds stood at around 100 in 2000, but snowballed to reach 680 in 2008. As the funds marked better investment returns than Western ones amid the global financial market crisis, investors are increasingly turning their eyes to them as a stable investment alternative.

“The Islamic finance industry felt the influence of the credit crunch and downturn in the global economy in 2008, with a drop in Sukuk issuance and a fall in the value of equity funds,” International Financial Services London said in a report.

“Islamic banks, however, have been less affected than many conventional banks because they are not exposed to losses from investment in toxic assets nor have they been dependent on wholesale funds, as they are prohibited from these activities,” it added.

Humane, Socially Responsible Islamic Finance

Islamic finance has some unique features as it is based on Shariah law, the Islamic code that entails the spiritual and moral obligations and duties of Muslims.

The most interesting is Sukuk, which is the Arabic name for a financial certificate and the Islamic equivalent of a bond. They are, however, very different from traditional bonds.

The Islamic world came to develop the unique type of bond as fixed income, as interest bearing bonds are not allowed in the religion. Shariah, which takes equitable distribution of wealth and equality in human rights as principles, regards Riba, or interest, as immoral profiteering. It doesn’t acknowledge the time value of money either.

Hence, collecting interest on bonds is prohibited. So how does one borrow money? The Islamic law only allows taking profit from tangible transactions like investing in real estate or leasing facilities.

With Sukuk, principal is paid back at maturation just as with other bonds. However, instead of receiving interest, those who lent or invested money get dividends from the investment. Those engaged in funding, or the bank, are regarded as partners in business, and receive part of the profits. Hence, it is like project financing or leasing.

Sukuk is an attractive way of funding as it offers money at a rate some 1.5-percent lower than the interest rates of U.S. or European lenders. The cost of raising money is also smaller as it does not require collateral.

Islamic finance requires that the investment comply with Islamic law and its investment principles. Assets should be managed according to Islamic investment principles.

It bans investing in “unethical” industries like gambling, cigarettes, pornography or armory. It also prohibits contracts that entail uncertainties, or transactions that are speculative. As such, hedging or derivative products are banned.

Currently, diverse financial products comprising not only bank products but also insurance and funds are being launched in Islamic finance, all of which should comply with Islamic law. Companies will go through probes by a Shariah committee ahead of providing products or services to see whether they fit the regulations.

It is also notable that Islamic finance levies only small arrears. It comes from the Islamic idea that businesses that fail to pay back on time are experiencing difficulties and they should receive assistance to survive hard times. Islamic finance, in this regard, is comparable to socially responsible investment.

Islamic Finance in Spotlight

Though the Islamic financial market also experienced a slowdown last year amid the global financial crisis, efforts are increasing around the world to lure the Islamic funds, refurbishing law and regulations and providing tax benefits.

“Since Islamic finance prefers long-term investment that lasts five years or more, it will help businesses in setting up funding portfolios,” KOTRA said.

It suggested that businesses that have difficulties in funding here should consider issuing Sukuk. “Since Sukuk pays part of profit from projects as dividend instead of interest, they can be more favorable than bank loans that levy high interest,” it explained.

It added that small-and medium-sized businesses, which have good business projects but little to offer as collateral, should consider Islamic finance as new funding source. Since one does not have to pay for funding until profit is incurred, the initial cost of funding is small.

Construction companies engaged in mega civil engineering projects in Islamic countries, especially in Southeast Asian countries, also have advantages if they choose funding through Sukuk. Shipbuilders and airliners can also think about it.

When Sukuk is issued in the country, biotechnology and IT businesses will enjoy the merits of Islamic finance. “Biotechnology and IT are industries that require long-term investment, and that comply with Shariah. These businesses can come up with huge profits when they succeed. It’s a win-win model for both,” KOTRA said.

Hence, countries around the world are noting the huge potential. Other Asian countries such as Japan, China and Singapore ― as well as the United Kingdom and the United States ― are aggressively seeking opportunities in Islamic finance.

Korea, a latecomer to the field, is bolstering efforts in Islamic finance, especially after the global financial crisis. The country, which has been depending too much on U.S. dollars, determined that Islamic money could be an option for diversification.

Its financial regulators, the Financial Services Commission and Financial Supervisory Service, also joined the Islamic Financial Services Board (IFSB) in 2008 as observers, and the country hosted a seminar on Islamic finance early this year.

Local financial businesses are also paying interest in the financing system, starting alliances with Islamic players.